Accounting By: F.Jiyana
Capital budgeting/
Project Appraisal
Name: ……………………
1
, Accounting By: F.Jiyana
Content
1.Introduction to capital budgeting and appraisal
2.Non-discounted methods
A. Payback period
B. Average Rate of Return (ARR)
3. Discounted methods
A. Discounted cash flow and net present value (NPV)
B. Internal rate of return ORR)
C. Weighted Average Cost Method (WAC)
2
, Accounting By: F.Jiyana
1. INTRODUCTION TO CAPITAL BUDGETING AND APPRAISAL
We learnt short-term decision-making methods in the lesson of Marginal and absorbtion
costing lesson. We used marginal costing (variable costing) methods in making Short
decisions such as making or buying a product, accepting or rejecting orders and
continuing or discontinuing a department.
In this lesson we are going to learn long-term decision-making methods which are
useful in making decisions about long term projects such as extending premises to
increase capacity or developing new products etc.
INVESTMENTS (LONG-TERM PROJECTS)
Any expenditure carried out by firm on projects that are expected to generate future returns,
e.g.: buying new, more efficient machinery, extending premises to increase capacity
developing new products. Such projects usually involve a considerable financial commitment
and, as likely returns may not occur immediately there may be a high degree of risk involved.
CAPITAL BUDGETING AND INVESTMENT APPRAISAL METHODS/
TECHNIQUIEs
These are the techniques to assess the financial benefits likely to be derived from different
projects in order to assist the decision-making process. These methods are
1. Payback period
2. Average Rate of Return (ARR)
3. Net Present Value (NPV)
4. Weighted Average Cost (WAC)
5. Internal Rate of Return (IRR)
3
, Accounting By: F.Jiyana
Non-discounted methods
A. Payback period
What is payback period?
Payback period is the length time it takes to recover or receive the income in cash required to
match the amount spent on the investment.
This measures the length of time it takes to recover the original financial outlay on an
investment project, how long it takes for net cash flow to cover the initial investment. Results
are expressed in terms of year or months.
(1) ABC building constructors have been received two projects from two customers at the
same time. At the moment they can accept only one project according to their capacity, They
can recover the investment cost from the income of two projects and then should hand them
over to the particular customer,
The projects information is as follows
Project 1 Project 2
Housing scheme School
Initial investment 1 000 000 1 000 000
Net cash flows
Year 1 200 000 400 000
Year 2 300 000 400 000
Year 3 300 000 200 000
Year 4 200 000 300 000
Calculate the payback period of each project and decide which project to be accepted by the
company according to payback period.
Ex: Housing scheme
year Net cash flow Cumulative cash
flow
0 1 000 000 (1 000 000)
1 200 000 (800 000)
2 300 000 (500 000)
3 300 000 (200 000)
4 200 000 0
There fore payback period is 4 years
4
Capital budgeting/
Project Appraisal
Name: ……………………
1
, Accounting By: F.Jiyana
Content
1.Introduction to capital budgeting and appraisal
2.Non-discounted methods
A. Payback period
B. Average Rate of Return (ARR)
3. Discounted methods
A. Discounted cash flow and net present value (NPV)
B. Internal rate of return ORR)
C. Weighted Average Cost Method (WAC)
2
, Accounting By: F.Jiyana
1. INTRODUCTION TO CAPITAL BUDGETING AND APPRAISAL
We learnt short-term decision-making methods in the lesson of Marginal and absorbtion
costing lesson. We used marginal costing (variable costing) methods in making Short
decisions such as making or buying a product, accepting or rejecting orders and
continuing or discontinuing a department.
In this lesson we are going to learn long-term decision-making methods which are
useful in making decisions about long term projects such as extending premises to
increase capacity or developing new products etc.
INVESTMENTS (LONG-TERM PROJECTS)
Any expenditure carried out by firm on projects that are expected to generate future returns,
e.g.: buying new, more efficient machinery, extending premises to increase capacity
developing new products. Such projects usually involve a considerable financial commitment
and, as likely returns may not occur immediately there may be a high degree of risk involved.
CAPITAL BUDGETING AND INVESTMENT APPRAISAL METHODS/
TECHNIQUIEs
These are the techniques to assess the financial benefits likely to be derived from different
projects in order to assist the decision-making process. These methods are
1. Payback period
2. Average Rate of Return (ARR)
3. Net Present Value (NPV)
4. Weighted Average Cost (WAC)
5. Internal Rate of Return (IRR)
3
, Accounting By: F.Jiyana
Non-discounted methods
A. Payback period
What is payback period?
Payback period is the length time it takes to recover or receive the income in cash required to
match the amount spent on the investment.
This measures the length of time it takes to recover the original financial outlay on an
investment project, how long it takes for net cash flow to cover the initial investment. Results
are expressed in terms of year or months.
(1) ABC building constructors have been received two projects from two customers at the
same time. At the moment they can accept only one project according to their capacity, They
can recover the investment cost from the income of two projects and then should hand them
over to the particular customer,
The projects information is as follows
Project 1 Project 2
Housing scheme School
Initial investment 1 000 000 1 000 000
Net cash flows
Year 1 200 000 400 000
Year 2 300 000 400 000
Year 3 300 000 200 000
Year 4 200 000 300 000
Calculate the payback period of each project and decide which project to be accepted by the
company according to payback period.
Ex: Housing scheme
year Net cash flow Cumulative cash
flow
0 1 000 000 (1 000 000)
1 200 000 (800 000)
2 300 000 (500 000)
3 300 000 (200 000)
4 200 000 0
There fore payback period is 4 years
4
